While the simplest way for a small business, a writer, to report their income and related expenses is on Schedule C of their personal tax return as a sole proprietor, the two most popular entities for authors thinking about expanding beyond a sole proprietor are LLCs and S-Corporations.
In general, outside of New York City and in most cities and states in the U.S., income earned by LLCs and S-Corporations is not taxed. For most authors who live outside of New York City and are consistently earning $200,000 or more per year–it makes sense to think about forming an entity, potentially an S-Corporation, and having all their income assigned to that.
Right now as a sole proprietor all of your income and expenses go on a Schedule C and you probably take the home office deduction. Individual tax returns that are reporting on a Schedule C and also a home office deduction are generally more likely to be audited than an individual tax return that does not have this information on it.
Roughly, I think less than 2 percent of individual tax returns are audited every year, but as they get bigger and bigger, the sole proprietor might start to think it might be safer not to have this large Schedule C potentially be scrutinized by the IRS. Instead, by starting an S-Corporation with, for example, $200,000 of income and $30,000-$40,000 of expenses per year, your return would be basically a smaller fish in a much larger corporate pond, and therefore potentially not as subject to IRS scrutiny.
It also allows you to be a bit less conservative in claiming your business deductions since you’re not so concerned about having to be subject to such scrutiny. The other reason to form an S-Corporation is that when you’re a sole proprietor, the net income that you earn is subject to self-employment tax, which is Social Security and Medicare.
If you’re a self-employed writer, a sole proprietor, and you’re earning $300,000 this year, you’re going to end up paying 15 percent in self-employment tax on the first $117,000 that you earn, and then on everything over this amount, you’ll pay self-employment tax of 3%. Once your self-employment income goes up over $117,000, the rate goes down from 15.3 percent to about 2.9 percent. That’s three percent of whatever you earn in excess of the $117,000 Social Security limit.
So the more you make the more this self-employment tax becomes relevant to you, and so for some people, they evaluate this and realize that they would save money by forming an S-Corporation. As I’ve said, an S-Corporation is is free of any federal and state income taxes. There are some costs to this. It’s a corporation, so it will have to file its own tax return, and because it is a separate entity it will need to obtain a tax ID number. You will have to open a new checking account to capture all the activity of the S-Corporation, and the S-Corporation will have to file a tax return, which you will most likely want an accountant do, so there will be some costs associated with that. It also would be required to report and file payroll taxes for the compensation it pays to you.
But those costs are much less than the tax savings that you’ll get. The S-Corporation would just report its income to the government; there would be no federal or state taxes. Of course net income from the S-Corporation is reported on your personal tax return as “Income from an S-Corporation”, and you would pay personal federal or state taxes the same way you would if it were on a Schedule C. But there’s no self-employment tax on that money.
That sounds a bit too good to be true, right? Well there is a little more to the story. The IRS doesn’t like it when S-Corporations earn $200,000, pay it all to the owner and the owner avoids all of the self-employment taxes. The solution is to have the S-Corporation pay the owner of the S-Corporation a reasonable salary, for example $75,000. That salary is subject to social security and Medicare. Which again is 15 percent, but 15 percent of $75,000 is a lot less than 15 percent on the first $117,000 and then the 3 percent on the excess. If you do the math, you save more than $10,000 in tis example as an S Corp.
So when you are starting to earn significant money from writing, it’s a good idea to sit down with an accountant and figure out whether it makes sense to incorporate, using your actual facts and circumstances.
The other type of entity writers might consider forming is an LLC. Most writers would form a single-member LLC, which for IRS purposes is a “disregarded entity”. What that means is the LLC would report its income on your return on Schedule C, the same way you would if you were still a sole proprietor.
In this approach you haven’t really accomplished anything for tax purposes. You didn’t save any money, you just incurred some additional costs without any benefits. So I would probably dissuade you from doing that unless you had legal reasons for forming the LLC.
Forming an LLC for legal purposes is a separate issue and you should consult a lawyer about that, but in my experience the protections you get from an LLC and an S-Corporation are very similar. But if you have legal concerns and also wanted to save some money on taxes, I would recommend the S-Corporation. It’s the most popular entity for the author that is starting to become very successful and wants to figure out ways to be more strategic on the taxes they pay.
Robert M. Pesce, Partner, Marcum LLP, provides significant tax saving strategies and business advice that enables his clients to become more profitable and efficient. email@example.com
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